Caterpillar is an Opportunity for Longer Time Horizons

Caterpillar (NYSE: CAT) has delivered a series of disappoints, the most recent in its third quarter earnings report. Management cut guidance for the third time this year, analysts reduced earnings estimates and some downgraded the shares from buy ratings.

All this said, the long-term outlook is still positive as earnings can bottom out on 2013 and growth reaccelerate behind an improving construction end market. At this point, many on the Street have become disinterested in the stock leaving an opportunity for patient investors more focused on long-term returns.

Patience Can Pay Off for Caterpillar Investors

The buy-side on Wall Street, which includes institutional investors like hedge funds, mutual funds and pension funds, generally builds their portfolios around what a stock will do over the next twelve months. There are exceptions and funds that specialize in going outside this box but for a few reasons, one year tends to be in focus and often even shorter time frames.

Institutions tend to look at few different factors when buying a stock, valuation, catalysts and momentum as well as some others. The valuation, like their time horizon tends to look towards the next twelve months. The second part, and often more important to institutions, are what catalysts can occur to drive the shares higher to this point. For a long position, this would include positive events that would improve the long-term outlook, earnings power and hence share price. These can be internal factors like margin improvement outpacing expectations, or external like improvements in a certain end markets. Cat lacks these catalysts according to many of the sell-side analysts at this time. That does not mean there is not value, it’s just uncertain as to what unlocks that value in the next 6-12 months.

Institutional investors often avoid these stocks despite the potential upside beyond 12 months as non-movement can drag on portfolio returns. Everyday investors can take advantage of these and use a longer investing horizon in order to beat the Street. They can take advantage of stock that lack current interest but are not broken stories. Caterpillar looks like a stock that fits this profile, the valuation is attractive, but there are not the clear catalysts and positive momentum many institutional investors look for.

Declines in Mining a Known Factor, Priced into the Shares

Caterpillar has faced falling demand in its Resources business which is tied to mining. Resources accounted for about a third of sales in 2012 but will likely fall to 20% of sales in 2014. Weakness here will have lightening impact on earnings. Caterpillar produces mining trucks and excavators via its historic business and electric shovels and underground equipment through its acquisition of Bucyrus. It is the largest manufacturer of mining equipment in the world. It essentially bought Bucyrus at or just prior to the peak in mining equipment which has been driven by increasing demand from China and the developing world for resources.

With global demand and growth relatively soft, combined with slowing growth in China and significant investments over the past decade increasing production, mining equipment demand has substantially declined. Based on guidance, Caterpillar anticipates a decline over 50% in its fourth quarter. However, the softness in this market is well known and largely priced into earnings for next year with most pricing in a mid-teens decline in 2014.

The resources business has been a headwind but can actually provide upside to the stock price just by the declines softening. If the bleeding stops, confidence in potential earnings power for 2015-2017 will improve and likely push the multiple higher as well as leading to EPS upside.

North American Construction Market Improving, Upside to European Forecast

Caterpillar remains the world’s largest market of construction equipment and improvements in the North American market should leading to growing sales in this business. Construction is around 40% of sales and Power Systems is the other 40%. The housing market is slowly improving and forecasts also from improvements in the commercial market. This can drive low double digit growth in North American construction equipment. In addition, Europe has been a headwind and this should remain relatively flat and could even be slightly up in 2014. Combined North America and its EMEA business will make up about 60% of sales next year. In terms of its remaining geographies in construction, Asia should also grow in 2014.

With a forecast for topline growth in construction, as well as Power System, and the headwinds from mining abating, earnings should again return to growth. The construction business likely has more than a few years left in its cycle and as mining bottoms out, the multiple should expand on the stock as it trades more in line with earlier cycle levels.

Current consensus is for earnings of $5.49 and $5.81 in FY13 and FY14, respectively. The stock trades at 15.2x and 14.4x these respective estimates. This is in line with its historic levels but the estimates have upside if construction continues to recover and starts to approach mid-cycle. In addition, the company is restructuring the mining business and can improve margins over the long-term. Historically, Caterpillar is a strong operator with a good management team which should help.

Conclusion

While this cycle has been anything but normal, the time to own industrials and machinery stocks like Caterpillar is early in the cycle or as earnings rebound. The groups’ earnings growth and shares tend to outperform their comparable index over that time. Caterpillar is at that point in the cycle. A more significant earnings recovery may take into 2015 – where consensus currently forecasts EPS of $6.71 – and investors with patience can benefit when they do. Downside seems somewhat limited at this point and the upside over the next 18 months is to levels in the $100 – $110 range.

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About John Clark

John has seven years of experience as an equity analyst following various stocks and sectors. As a senior equity analyst, he received awards from the Wall Street Journal and Financial Times for his writing.